A 1031 exchange (also known as like-kind exchange) is a powerful tax-deferral strategy that affords significant tax advantages to real estate investors. A 1031 exchange occurs when a taxpayer sells a property and simultaneously acquires a same type of property. The key advantage of a 1031 exchange is that it allows the taxpayer to defer the capital gain on disposal of a property. Another tax-deferral strategy commonly used is a cost segregation study. Performing a study allows property owners to identify a portion of the costs as personal property assets and land improvements, which have much shorter depreciable lives.
1031 Exchange Strategy
Prior to the Tax Cut and Jobs Act (TCJA), taxpayers could defer a tax gain on the exchange of both real property and personal property. After January 1, 2018, a 1031 exchange only applies to real property that is not held primarily for sale. The deferral of a gain or loss on the exchange of personal property is eliminated. As result, when a taxpayer sells a property through a 1031 exchange and if a cost segregation study had been done on the property being sold, only the land and the building are eligible for the tax deferral. The exchange of personal property will result in a taxable gain.
Cost Segregation Strategy
The taxpayer can take advantage of 100% bonus depreciation and/or Section 179 deduction by performing a cost segregation study on the acquired property to accelerate tax depreciation deductions. A Section 179 deduction is an election made by the taxpayer to deduct the entire cost of the property in the year it is placed in service. After the TCJA, taxpayers can take a 100% bonus depreciation on all qualifying property, whether new or used, that was placed in service after September 27, 2017 and before January 1, 2023. In addition, improvements made to nonresidential property such as roofs, heating and air conditioning, fire protection systems, and security systems qualify for a Section 179 deduction in the first year they are placed in service. The TCJA also increased the Section 179 limitation to $1 million and increased the phase-out threshold to $2.5 million for property placed in service after December 31, 2017.
A cost segregation study can be beneficial on both sides of a real estate exchange, but will require careful tax planning. Under the current rules, taxpayers cannot defer the Section 1245 recapture tax, which is ordinary income tax that the taxpayers may have to pay on the gain recognized from sale of personal property. However, the recapture tax could offset that with the accelerated first-year depreciation deductions from a cost segregation study on the newly purchased property, or any other property, in a portfolio.
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